Slides by Matthew Will
47
Risk and Return Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 8 ©The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
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Principles of Corporate Finance Brealey and Myers Sixth Edition. Risk and Return. Slides by Matthew Will. Chapter 8. Irwin/McGraw Hill. The McGraw-Hill Companies, Inc., 2000. Topics Covered. Markowitz Portfolio Theory Risk and Return Relationship Testing the CAPM - PowerPoint PPT Presentation
Transcript of Slides by Matthew Will
Risk and Return
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will Chapter 8
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
8- 2
Topics Covered
Markowitz Portfolio Theory Risk and Return Relationship Testing the CAPM CAPM Alternatives
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Markowitz Portfolio Theory
Combining stocks into portfolios can reduce standard deviation below the level obtained from a simple weighted average calculation.
Correlation coefficients make this possible. The various weighted combinations of stocks
that create this standard deviations constitute the set of efficient portfoliosefficient portfolios.
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Markowitz Portfolio Theory
Price changes vs. Normal distribution
Microsoft - Daily % change 1986-1997
0
100
200
300
400
500
600
-10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%
# of
Day
s (f
requ
ency
)
Daily % Change
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Markowitz Portfolio Theory
Price changes vs. Normal distribution
Microsoft - Daily % change 1986-1997
0
100
200
300
400
500
600
-10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%
# of
Day
s (f
requ
ency
)
Daily % Change
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Markowitz Portfolio Theory
Standard Deviation VS. Expected Return
Investment C
0
2
4
6
8
10
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18
20
-50 0 50
%
prob
abili
ty
% return
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Markowitz Portfolio Theory
Standard Deviation VS. Expected Return
Investment D
0
2
4
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8
10
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18
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-50 0 50
%
prob
abili
ty
% return
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Markowitz Portfolio Theory
Bristol-Myers Squibb
McDonald’s
Standard Deviation
Expected Return (%)
45% McDonald’s
Expected Returns and Standard Deviations vary given different weighted combinations of the stocks.
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Efficient Frontier
Standard Deviation
Expected Return (%)
•Each half egg shell represents the possible weighted combinations for two stocks.
•The composite of all stock sets constitutes the efficient frontier.
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Efficient Frontier
Standard Deviation
Expected Return (%)
•Lending or Borrowing at the risk free rate (rf) allows us to exist outside the
efficient frontier.
rf
Lending
BorrowingT
S
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Efficient Frontier
Example Correlation Coefficient = .4
Stocks % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%
Standard Deviation = weighted avg = 33.6
Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%
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Efficient Frontier
Example Correlation Coefficient = .4
Stocks % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%
Standard Deviation = weighted avg = 33.6
Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%
Let’s Add stock New Corp to the portfolio
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Efficient Frontier
Example Correlation Coefficient = .3
Stocks % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New CorpNew Corp 3030 50%50% 19% 19%
NEW Standard Deviation = weighted avg = 31.80
NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%
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Efficient Frontier
Example Correlation Coefficient = .3
Stocks % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%
NEW Standard Deviation = weighted avg = 31.80
NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%
NOTE: Higher return & Lower risk
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Efficient Frontier
Example Correlation Coefficient = .3
Stocks % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%
NEW Standard Deviation = weighted avg = 31.80
NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%
NOTE: Higher return & Lower risk
How did we do that?
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Efficient Frontier
Example Correlation Coefficient = .3
Stocks % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%
NEW Standard Deviation = weighted avg = 31.80
NEW Standard Deviation = Portfolio = 23.43
NEW Return = weighted avg = Portfolio = 18.20%
NOTE: Higher return & Lower risk
How did we do that? DIVERSIFICATION
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Efficient Frontier
A
B
Return
Risk (measured as )
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Efficient Frontier
A
B
Return
Risk
AB
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Efficient Frontier
A
BN
Return
Risk
AB
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Efficient Frontier
A
BN
Return
Risk
ABABN
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Efficient Frontier
A
BN
Return
Risk
AB
Goal is to move up and left.
WHY?
ABN
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Efficient Frontier
Return
Risk
Low Risk
High Return
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Efficient Frontier
Return
Risk
Low Risk
High Return
High Risk
High Return
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Efficient Frontier
Return
Risk
Low Risk
High Return
High Risk
High Return
Low Risk
Low Return
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Efficient Frontier
Return
Risk
Low Risk
High Return
High Risk
High Return
Low Risk
Low Return
High Risk
Low Return
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Efficient Frontier
Return
Risk
Low Risk
High Return
High Risk
High Return
Low Risk
Low Return
High Risk
Low Return
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Efficient Frontier
Return
Risk
A
BNABABN
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Security Market Line
Return
Risk
.
rf
Efficient PortfolioRisk Free
Return =
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Security Market Line
Return
Risk
.
rf
Risk Free
Return =
Market Return = rm
Efficient Portfolio
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Security Market Line
Return
Risk
.
rf
Risk Free
Return =
Market Return = rm
Efficient Portfolio
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Security Market Line
Return
BETA
.
rf
Risk Free
Return =
Market Return = rm
Efficient Portfolio
1.0
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Security Market Line
Return
BETA
rf
Risk Free
Return =
Market Return = rm
1.0
Security Market Line (SML)
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Security Market LineReturn
BETA
rf
1.0
SML
SML Equation = rf + B ( rm - rf )
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Capital Asset Pricing Model
R = rf + B ( rm - rf )
CAPM
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Testing the CAPM
Avg Risk Premium 1931-65
Portfolio Beta1.0
SML
30
20
10
0
Investors
Market Portfolio
Beta vs. Average Risk Premium
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Testing the CAPM
Avg Risk Premium 1966-91
Portfolio Beta1.0
SML
30
20
10
0
Investors
Market Portfolio
Beta vs. Average Risk Premium
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Testing the CAPM
0
5
10
15
20
25
Average Return (%)
Company size
Smallest Largest
Company Size vs. Average Return
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Testing the CAPM
0
5
10
15
20
25
Average Return (%)
Book-Market Ratio
Highest Lowest
Book-Market vs. Average ReturnBook-Market vs. Average Return
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Consumption Betas vs Market Betas
Stocks (and other risky assets)
Wealth = marketportfolio
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Consumption Betas vs Market Betas
Stocks (and other risky assets)
Wealth = marketportfolio
Market risk makes wealth
uncertain.
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Consumption Betas vs Market Betas
Stocks (and other risky assets)
Wealth = marketportfolio
Market risk makes wealth
uncertain.
Standard
CAPM
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Consumption Betas vs Market Betas
Stocks (and other risky assets)
Wealth = marketportfolio
Market risk makes wealth
uncertain.
Stocks (and other risky assets)
Consumption
Standard
CAPM
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Consumption Betas vs Market Betas
Stocks (and other risky assets)
Wealth = marketportfolio
Market risk makes wealth
uncertain.
Stocks (and other risky assets)
Consumption
Wealth
Wealth is uncertain
Consumption is uncertain
Standard
CAPM
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Consumption Betas vs Market Betas
Stocks (and other risky assets)
Wealth = marketportfolio
Market risk makes wealth
uncertain.
Stocks (and other risky assets)
Consumption
Wealth
Wealth is uncertain
Consumption is uncertain
Standard
CAPM
Consumption
CAPM
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Arbitrage Pricing Theory
Alternative to CAPMAlternative to CAPM
Expected Risk
Premium = r - rf
= Bfactor1(rfactor1 - rf) + Bf2(rf2 - rf) + …
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Arbitrage Pricing Theory
Alternative to CAPMAlternative to CAPM
Expected Risk
Premium = r - rf
= Bfactor1(rfactor1 - rf) + Bf2(rf2 - rf) + …
Return = a + bfactor1(rfactor1) + bf2(rf2) + …
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Arbitrage Pricing Theory
Estimated risk premiums for taking on risk factors
(1978-1990)
6.36Mrket
.83-Inflation
.49GNP Real
.59-rate Exchange
.61-rateInterest
5.10%spread Yield)(r
ium Risk PremEstimatedFactor
factor fr
